Juniors’ performance a marginal issue

Most small industrial stocks are likely to experience margin pressure this financial year and possibly in 2011-12, but this risk has not been fully factored in by analysts.

This means that investors should brace for more market volatility, further earnings downgrades being likely to be a dominant theme in the sector over the next few months given sluggish demand on the one hand, and rising costs on the other.

Profit margins will be heavily scrutinised because margin performance often gives an indication on the quality of the business.

An industry leader with an edge over the competition often generates fatter margins than their peers – leading to a superior return on invested capital.

Thorn Group (TGA)

From that perspective, household goods leasing company Thorn Group could potentially outperform during these uncertain times after posting a decent full-year result this morning.

Management posted a 40 per cent surge in normalised net profit after tax of $23 million on an 8.6 per cent increase in sales to $157.6 million for the year ended March 31, 2011.

Full-year dividend of 8.49¢ a share was also more than a third higher than last year. While net profit was largely in line with consensus, revenue and dividend came in a little below expectations.

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But any disappointment was offset by Thorn’s bullish outlook for 2011-12 and a strong uplift in operating margin – not an easy feat in a tough retail environment.

Earnings before interest, tax, depreciation and amortisation (EBITDA) margins grew strongly for the third consecutive year to 21.6 per cent from 17.9 per cent in the pervious year and a little more than 14 per cent in 2008-09.

Thorn Group, which owns the Radio Rental chain, expects a “substantial increase" in earnings in 2011-12 that is driven by organic growth and contribution from its recently acquired receivables management business, National Credit Management.

The stock is trading on an attractive one-year forward price-earnings multiple of 9 times - close to a 19 per cent discount to other retailers.

This discount is not justified given that Thorn’s business is not as cyclical as demand for its “rent, try, buy" offering seems to increase when household budgets are feeling stretched.

Further, the company benefits for recurring revenue streams from its leasing contracts, which gives its earnings greater predictability compared with traditional retailers.

The stock jumped 6.6 per cent to $2.11 this morning.

Imdex (IMD)

Drilling consumables and equipment company Imdex is another that leads it peers when it comes to operating margins.

What is even more encouraging is that margins are expected to continue to grow strongly due to the high levels of exploration activity and as client rig utilisation reaches capacity this calendar year.

This, in turn, will drive demand for its drilling products and the benefits are already being felt as management reported a record performance in the March quarter when revenue hit $49.2 million – giving the company an impressive earnings before interest, tax and amortisation (EBITA) margin of 24.4 per cent compared with the 15.8 per cent margin it produced during the same period last year.

Argonaut Securities estimates that EBITA margin will expand 7.4 percentage points in the current financial year to 22.8 per cent before hitting 24 per cent in 2011-12.

The broker is also tipping revenue to surge 48.5 per cent to $199 million in 2010-11 and 24.6 per cent the following year that is driven by organic and acquisitive growth.

All brokers polled on Bloomberg share Argonaut’s enthusiasm for Imdex and are rating the stock a “buy" with an average price target of $2.47.

The stock was trading 1¢ firmer in early trade at $2.06.

Technology One (TNE)

The business software solutions company’s expected margin expansion isn’t quite as impressive when compared with Thorn or Imdex, but it’s still attractive relative to its peers.

There was a notable increase in costs, particularly in research and development, but that didn’t stop management from posting a 28.9 per cent rise in net profit to $7.4 million for the six months to the end of March that was ahead of consensus expectations.

Technology One revised its expenses growth forecast to about 14 per cent from 10 per cent but that is at least partially offset by an increase in its licensing fees.

Net profit for the year ending September 2011 is forecast to grow between 10 per cent and 15 per cent and Moelis & Company believes that EBITDA margin will edge up 1.3 percentage points to 20.7 per cent for 2010-11 and will hit 20.9 per cent the following year.

While the stock doesn’t look cheap on the broker’s 2011-12 P/E estimate of about 14.5 times, it still upgraded the stock to a “buy" as Technology One’s positive near-term growth profile stands out in a two-speed economy, which is crimping growth for most non-resource related companies.